Saturday, January 31, 2009

Better way to stimulate the economy.

Leaving aside my doubts about the fairness of the currently proposed stimulus packages, government could still justify executing them if they were effective in helping the economy. Here I will try to rationalize why they won't be, and propose a much more effective and ethical way to spend taxpayer money on economic improvement.

First let's recognize that recessions have both desired and undesired effects on the economy. Recessions happen when the rate at which non-viable businesses die temporarily exceeds the rate at which new business is created. The increase in the destruction rate can be set off by many different reasons, but remember that that rate is never zero even in the best of times, and this destruction is both necessary and healthy. The unhealthy (undesirable) effects are the self-reinforcing negative feedback loops that usually accompany recessions - and these effects are mostly psychological.

Consider this example. Let's suppose people think the country is in a recession. Naturally, they expect job cuts and start worrying about their own security. In a country like USA loss of a job is a pretty severe blow to most families - you lose medical insurance, and unemployment assistance is only available for a short time. Therefore, anyone worried about their job naturally restricts their spending and tries to save as much as possible to protect themselves. If half of the families in US try to cut their spending by just 5%, a lot of the industries that rely on discretionary and semi-discretionary income could see huge drops in revenues, up to 50%. This may happen even if the actual unemployment rate does not increase at all, purely due to the fear. Of course, as revenues fall, this fear of job loss becomes a self-fulfilling prophecy as businesses contract and lay off workers. From here on, this becomes a self-reinforcing feedback loop. And that is the part of a recession that is not justified by the economic fundamentals and is entirely undesirable. Businesses that are viable in normal times suddenly find themselves bankrupt, and so on.

The idea behind stimulus based on creating arbitrary government projects is to pick up the slack in spending that workers who are unemployed (or insecure) have caused, and thus help healthy businesses live through the downturn. This is where things get tricky, however. This spending-for-the-sake-of-spending stimulus idea was not bad in the 1930s, or even 1950s, when most of the income was spent on necessities like food, and not a whole lot of spending could be called fully discretionary. A lot of decrease came from the people who actually become unemployed, and therefore the negative feedback was weaker (since the purely psychological component was much smaller).

Today, the economy looks much different. With 70% of it being in the service sector, the discretionary spending is a very big fraction of total, and it is much easier for people to cut their expenses. This means that the psychological negative feedback is much stronger than that driven by pure financial fundamentals. The stimulus now is supposed to pick up the tab not only for those who are out of funds, but also for those who have money but decided to willingly withdraw from the excessive consumption. Trying to counter that consumer withdrawal with government spending is like pissing against the wind, or shoveling against an avalanche. You achieve little, and risk getting yourself in trouble.

Instead, government should try to directly attack the purely psychological component of the negative feedback loop. How do you do that? By reducing the incentive to save for the rainy day.

People are worried that without the jobs, there would be no medical insurance and no food or housing for their families. Government could just give a blanket guarantee on these things and eliminate most of these worries entirely. It would have a lot more effect on the economy than direct government spending on random projects, like in Obama's plan. It would also cost a lot less.

To understand the scale of the numbers involved, remember that Obama's universal healthcare plan is supposed to cost additional 100$ billion a year. So if we took just the original TARP money we could eliminate all healthcare worries in the country for 4 years. Remember that Fed and the government already given guarantees worth over 10$ trillion dollars to the banking sector. Imagine how much less money would we need if we simply guaranteed food stamps and housing stamps for anyone who gets laid off? I bet that would do a lot more good than just doing something for the sake of spending money.

That would also be a more ethical way to use taxpayer funds, since no money would go to the private sector, and even government itself would get a very small windfall, since most of these social guarantees could be provided by existing agencies like Medicare without major increases in funding.

Friday, January 30, 2009

Why TARP #2 will still look like theft.

As Fed has become powerless (and all but irrelevant) in the recent months, the powers that be have been trying fiscal measures. The original TARP has now been recognized by most as a failure, mostly because the money pretty much went to line up the pockets of the bankers at virtually no upside for the taxpayer. See for example how Merrill Pay Was Down Only Slightly in 2008 From 2007 Levels. At the same time, most people don't realize how close the whole financial system was to a complete breakdown (as in, no ATMs, no credit cards working) in the October of 2008. It is quite likely that TARP has prevented that event. So even though the plan resembled theft much more than a rescue mission it did do some good.

Now we have Obama's proposed 825$ billion stimulus that is being debated in Congress; and on paper it looks better, since money seems to be intended to go to various 'productive' projects like education, infrastructure maintenance, etc.

I already wrote in the previous post about my distrust for any centrally planned initiatives, and about the dangers of fiscal recklessness, but for the moment I want to leave these aside and present you with a little piece from Bloomberg about how government projects actually work in practice: Hidden Bonuses Enrich U.S. Government Contractors. Here comes the choice cut:

...the government spent $368.4 billion on all contracts in 2008, and Republican Oklahoma Senator Tom Coburn estimates that about $100 billion of that was wasted.

US government actually managed to dwarf the numbers that caused recent outrage about Wall Street bonuses: 16$ billion in bonuses, compared to unknown trillions of taxpayer money spent on maintaining the financial system alive.

That is why I don't believe Obama's TARP will be more ethical than Paulson's. Money is still going to line up the pockets of the bureaucrats, just slightly different ones.

There is a way to effectively spend money for economy stabilization, but it is not what the corrupt politicians in Washington are doing. We could have much more bang for the buck spending this money where it really helps, but I probably should write a separate post about it.